China’s Housing Market – an Inflationary Bubble, or a Sustainable Boom?

Once again, inflation increased in China last month by more than economists expected, as rising commodity costs and inflows of capital threaten to overheat economies across Asia.  China’s consumer prices rose 5.4% from a year earlier, the fastest pace since 2008, according to statistical reports coming out of China.  Four interest-rate increases in China since the start of 2010 have failed to tame price pressures in the world’s fastest-growing major economy.

Although in China inflation is largely driven by food costs, which rose 12% in March from a year earlier, Beijing is very concerned about the effect that rising property prices in many cities are having on inflation.  China’s fixed-asset investment in non-rural areas, a reliable indicator of construction activity, rose 25% in the January-March period from a year earlier.  Strong growth in property investment, which rose 34.1% in the first quarter from a year earlier, also demonstrates that restrictions on speculation and oversupply in the real estate sector did not impact incentives to invest.

The real estate market is immensely important to the Chinese economy.  With few other outlets for investment (depositing money in a Chinese bank is a losing investment, given low interest rates and high inflation), many families have been directing their savings into apartments, resulting in what some analyst describe as a bubble.  A recent article in the New York Times by Andrew Jacobs, describes the many undesirable repercussions of China’s unrelenting real estate boom.  Since 2007 real estate prices nationwide have risen by 140%, and during the past eight years by as much as 800% in Beijing.

However, a recent study by the Economist Intelligence Unit (EIU) is painting a different picture.  “China is not facing a major housing bubble, although there could be a short-term mild correction.  The Economist Intelligence Unit’s new models of population and incomes in China’s cities point to strong underlying demand for housing throughout the next decade.  They indicate that housing demand in China is growing so quickly that a correction in the next couple of years will be short-lived.”

Non-the-less, current market predictions for the housing market are rather grim.  Moody’s Investors Service downgraded China’s property sector last week to “negative” from “stable,” on concerns that rising interest rates and reduced bank lending would deteriorate credit conditions and dampen demand.  It appears that home purchasing restrictions had a significant impact on new home sales, with sales in Beijing down nearly 40% in the first quarter of 2011, compared to the previous three months.  The Moody’s report also said that reduced bank lending, rising interest rates and increasing property supply would inevitably bring down sales and profit margins while also worsening the balance sheet liquidity for some developers.

The nation’s real-estate obsession is especially noteworthy given China’s relatively recent embrace of home ownership.  According to Mr. Jacob’s, the sale of residential property was not allowed until the late 1980s, and even then under a leasehold system that gives buyers 70 years of ownership.  Today, about two-thirds of all Chinese under 40 own their own homes, slightly higher than the average for Americans of the same age group.  The frenzy starts with the local governments that sell off land at steep prices, and is further exacerbated by overeager developers who force residents out of old neighborhoods.  China’s response to the global financial crisis, a stimulus package which channeled a record 17.5 trillion RMB ($2.7 trillion) of lending over 2009 and 2010, is also contributing to the current housing situation.

New supply would also flood the market after Beijing pledged to roll out more affordable housing amid growing public concern over rising prices, with plans to build 10 million low-income apartments this year.  According to the Moody’s report, the government’s priorities of maintaining social stability (by controlling inflation and containing any emerging property bubble) will continue to heavily influence the direction of the property market.  Moody’s downgrade came a day after Premier Wen Jiabao told a cabinet meeting that home prices were still rising fast in some cities and reaffirmed intentions to keep tightening policies in place against property speculators.

Beijing has rolled out a number of measures to curb housing inflation in the past year and a half, including four rises in interest rates since October and restrictions on multiple home purchases.  On Sunday, China raised banks’ reserve ratio requirements for the fourth time this year.  In particular, China’s central bank said it was raising the reserves that commercial banks must deposit with the central bank to 20.5%, up from 20% previously, with effect from April 21.  Premier Wen Jiabao even said last week that China’s central bank is considering increasing the RMB’s flexibility to help counter inflation.

EIU Report on the Sustainability of China’s Housing Boom –

Although soaring house prices in Chinese cities have led to widespread concerns of a property bubble, and the repercussions of a major collapse would be severe enough to send the world into a mini-recession and to cause serious damage to resource-focused economies, the EIU report reaches some more optimistic conclusions than Moody’s recent downgrade.

Furthermore, although the EIU report also agrees that China does have a high level of per-head floor space given its income levels, it does not believe that this will lead to a structural collapse of housing demand.  The EIU report argues that “China’s love affair with housing is driven by cultural factors linked to the gender imbalance, and relatively light taxation of housing as an investment.  Neither of these factors is likely to change significantly this decade.”

On the other hand, demand for housing in China has both global and domestic implications.  The EIU report concludes that “the global commodity demand set off by China’s housing industry will continue to underpin commodity prices, particularly for steel and oil.”  The EIU report also argues that “within China, the housing industry is associated with broad opportunities in construction, retail and transportation.”

Chinese Society Unique Characteristics:

Although there is no doubt that China remains the most over-housed countries, according to the EUI report there are a number of characteristics of the Chinese society that may account for the countries housing exuberance:

• Property sector taxation: The absence of a significant nationwide property tax, such as that enforced in most other countries, greatly boosts the attractiveness of real estate in China.  China has just begun to experiment with property taxes, but as they are currently at such a low level they are having minimal impact.

• Small households: The average size of a Chinese household is 3.3 persons (2.8 for urban households), which is relatively low for a developing country.  The one-child policy has clearly played an important role, but aging will also contribute to the growth of single households (men tend to die earlier than women), as will the gender imbalance and changing family values.

• Gender imbalance: China has the world’s most skewed gender ratio among young people, which has multiple implications for housing.  A small but thorough pool of researchers contend that gender imbalance, combined with a materialistic approach to marriage, is the reason behind China’s high household savings rate.  A higher ratio of men to women in China means that the latter can be more selective about their spouses, while the former must try harder.  Young men thus save feverishly, often with the help of their parents, to be able to offer their desired partners a suitably impressive home.

• Building quality: While Chinese citizens enjoy living space that is almost on a par with their much richer Japanese counterparts, the quality of buildings is likely to be on a different level.  It is difficult to obtain objective benchmarks on building quality across countries, but anecdotal evidence from China certainly suggests lower-quality construction.  According to Pan Jiahua, a researcher at the Chinese Academy of Social Sciences, the average lifespan of a Chinese building is 30 years, compared with 132 years in the UK. … Shoddier construction holds costs down, so it is quite possible that there is a trade-off between home size and building quality.

Risks and the impact of housing on steel and energy:

The significant role that China’s property sector plays in driving the domestic economic cycle is well documented and not in doubt.  However, China’s property sector is also increasingly important for other global sectors.

According to the EIU report, “Chinese demand is crucial for determining global prices of key commodities ranging from iron ore and oil to aluminium and copper. …  As a broad driver of economic activity, housing construction sets off a range of indirect demands for commodities and energy that are important to measure.”  One example provided by the EIU report has to do with the close link between housing construction and demand for cars, as new home owners in more affordable satellite towns rely more on cars for commuting.  Therefore, the resulting increase in demand for cars requires further inputs of steel and energy.

The EIU report goes as far as to forecast what a given level of housing activity means to demand for total steel and energy.  “Over the five years to 2014, as floor space per capita head rises by 25%, steel demand will rise by 22% and energy demand by around 50%.”  Such an increase will have a dramatic impact on global markets.  “The main winners will be countries exporting iron ore and oil, while consumers everywhere will face relatively higher prices.”

A free summary of the report (The Sustainability of China’s Housing Boom) is available at:

http://www.eiu.com/public/topical_report.aspx?campaignid=china_realestate_wp